“There is an invisible tipping point. When we get there, it’s far too late.”
I’ve used this quote from Baupost Group Chief, Seth Klarman, before. When he said it, he was alluding to America. In Europe, I think we’re there. Some Tipping Points are invisible to many, but crystal clear to Mr. Macro Market. You just have to be humble enough to let him show you the way.
For all of you who got this right in 2008, you know exactly what I am talking about. The interconnectedness of Global Macro markets has been clear to you for quite some time now. Considering your portfolio risk from the narrow vantage point of one country and its credit risk is as obsolete as Keynesian Economics.
This systemic problem in our industry’s analytics was born in academia and now it thrives in government. These central planners of the world unite and focus on “risks” after they have been priced in. In doing so, they are blinded by what’s coming next.
Consider the #1 headline on Bloomberg this morning:
“MERKEL, SARKOZY TO OUTLINE POSITION ON GREEK DEBT.”
Meanwhile, as these left leaning Europeans prepare for their 3 hour lunch in Brussels, the rest of the world’s interconnected risk continues to be priced on a tick.
From a Chaos Theorists perspective (an alternative to Keynesian dogma), the deepest simplicity that I can achieve in explaining how this works is watching every grain of sand (market data points - including Price, Volume, and Volatility signals) fall onto my screens – one by one. Unless you have a process to contextualize Tipping Points, how will you know which grain of sand will collapse the pile?
Hedgeye doesn’t have its feet on the floor earlier than any other firm we compete with for bailouts and giggles. We do it because someone needs to be awake every morning, watching the grains of sand.
This morning’s moves in Global Macro are a critical example of what I am ultimately trying to signal – timing:
- Intel (US equity market barometer) flags that margins are peaking last night at the close = US FUTURES DOWN
- China comes out with a brutal manufacturing PMI print of 48.8 in July (versus 50.1 in June) = ASIA DOWN
- Germany then hits the tape with an equally bad PMI print (versus expectations as China’s) = DAX DOWN
There’s obviously a lot of other things going on out there, but the principles of Chaos or Complexity Theory hinge on simplifying what factors have the largest impacts to the ecosystem you are analyzing. US Tech, China, and Germany are large factors.
There’s a difference between correlation and causality. The fundamental slowing of economic growth, globally, is causal to markets and the companies that operate within them. Whereas measuring the correlation between these Global Macro data points and market prices is trivial – if you have a process to absorb them:
- US Equities are going to re-test intermediate-term TREND line support (1319 SP500) this morning
- Chinese Equities had their biggest down day in 3 weeks, closing down -1% at 2765 on the Shanghai Composite
- German Equities are breaking their intermediate-term TREND line of 7198 on the DAX
What do any of these things have to do with Greece?
Exactly. Nothing. Greece is gone. Caput. Gonzo. Au-revoir.
Greek equities have crashed, twice, in the last 2 years and the Greek bond market is illiquid and dark. Europig politicians are not going to be able to do a damn thing to save Greece from themselves. Default and/or restructuring is the only way out.
So they may as well move to the crème brule in Brussels today and focus on what really matters to both the EU and the Euro – Germany’s economic slowdown and Spain/Italy bumping up against massive debt maturities in August and September (it’s July). Focusing on Greece today is far too late.
My immediate-term support and resistance ranges for Gold (we’re long), Oil (no position), and the SP500 are now $1, $95.47-99.08, and 1, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
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BJRI is one of the casual dining names that defies gravity in the current environment, although the skeptics abound with 64.7% of sell-side ratings calling the stock a “Hold” and 5.9% rating it “Sell”. Buy-side sentiment became less bearish throughout the quarter, declining from 19% of the float to 16%.
Not surprisingly, BJ’s restaurant is currently being awarded a lofty multiple of 17.8x EV/EBITDA NTM. Considering that DIN is currently trading at 9.3x, as the second most highly-valued company in the casual dining space behind BJRI, investors are clearly willing to pay up for the growth that BJ’s offers.
In terms of top-line trends, the company bounced back strongly post-recession. Last quarter’s company same-restaurant sales growth of 7.8% growth was an acceleration from the 4Q10 number despite a far more difficult compare for the first quarter. Management struck a cautious tone regarding the second quarter, stating on March 20 that, excluding the shift in the Easter holiday and spring break vacations, same-restaurant sales were estimated to be trending at approximately +5.5%.
This would imply a sequential slowdown in two-year average trends of 70 basis points. Looking at California Sales Tax receipts for the second quarter, it seems that consumer spending in the Golden State was robust during April, May and June. The two-year average trend, however, in sales tax receipts was slightly down. Approximately half of BJRI’s restaurants are in California so the chart below suggests that strong 2Q trends could be in store for BJ’s California units.
FORWARD LOOKING COMMENTARY FROM THE 1Q11 EARNINGS CALL
SALES TRENDS - POSITIVE BUT CAUTIOUS OUTLOOK
- “Sales comparisons continue to be favorable to date for the second quarter.”
- “Currently, we anticipate having about 3% of menu pricing for the second quarter and then menu pricing in the mid 2% range in both Q3 and Q4 for this year.”
- “The recovery of the economy, the job market and consumer asset values all continue to be slow, choppy and geographically uneven. Foreclosure rates and unemployment rates are still quite high in many of the states that we operate restaurants. Additionally, as we all know, consumers are facing significantly higher grocery and gasoline prices, which could negatively impact the discretionary spending on restaurant occasions in general going forward.”
- “So in light of all of these external factors that are outside of our control, our sales volumes remained difficult even for us to reliably predict so we don't even try to publicly predict them. And we also recommend that those who are in the business of predicting sales keep their expectations on the conservative side.”
- “Additionally our comparable sales comparisons become increasingly more difficult as 2011 progresses.”
- “Our guest traffic and throughput continue to benefit from improved operational execution driven by more complete management staffing levels and also by what we internally call our Quality Fast operational initiative.”
- “We've intentionally kept most of our pricing power in reserve during the past couple of years.”
- “Furthermore, I would expect that our weekly sales average will be a little less than our comparable restaurant sales for at least the second quarter of this year until some of our strong new restaurant openings from the latter part of the second half of 2009 enter our comparable sales base.”
- “Additionally, as we mentioned, fiscal 2011 will be a 53-week year for us and therefore Q4 will be comprised of 14 weeks as compared to our traditional 13-week quarters.”
SECULAL TRENDS - POSITIVE BIAS
- “We continue to believe that the battle for casual dining market share is going to be a much more significant factor going forward than it has been historically, primarily because the casual dining segment doesn't have as strong of a macroeconomic tailwind that it enjoyed during the past couple of decades.”
- “Now having said that, annual casual dining segment sales are still estimated to be well north of $80 billion and annual sales growth for casual dining chains, excluding the independent casual dining operators, is still expected by most observers to be in the 4% to 5% range for the next couple of years. Now that 4% to 5% projected increase in casual dining chain sales would likely be comprised of a 2% to 3% annual increase in capacity and a 2% or so increase in sales on the existing capacity base.”
- Increased capacity base as measured by total restaurant operating lease in the low double-digits during the next couple of years in the approximate range of 12% to 13%. Additionally, over the longer run, we also expect annual sales increases on our existing capacity base to eventually settle in the 2% to 3% range, assuming a more normalized cost and operating environment.
- So it's our intention to continue to gain market share at a much higher rate than the expected growth rate for the overall casual dining segment.
- “With respect to our new restaurant expansion plan, we've successfully opened two new restaurants during the first quarter of 2011. We remain very pleased with the initial sales volumes of those two new restaurants. We have seven restaurants currently under construction for potential openings later this year. We remain solidly on track to open as many as 12 to 13 new restaurants during 2011 and achieve our capacity growth goal for this year. And we're well under way in securing high quality locations for potential new restaurant openings in 2012.”
- “Our development plan for this year calls for all of our new restaurants to be developed within a 13 state footprint which will allow us to continue leveraging our brand position, consumer awareness, supply-chain infrastructure and field supervision resources.”
- “All of our remaining 2011 openings have been identified and secured with signed leases or letters of intent. Seven of these restaurants are currently under construction.”
- “As of today we still are targeting approximately $75 million in gross capital expenditures for 2011, which we anticipate funding from cash flow from operations as well as our expected landlord allowances and our current cash and investment balances.”
- “Anticipate opening costs of approximately $1.7 million to $2 million in the second quarter related to the expected three new openings in the quarter plus preopening rent for restaurants expected to open later in 2011.”
- “While we are currently beginning to see some relief in our produce costs, I still anticipate higher cost of sales for the remainder of 2011.
- “In regard to the cost of sales for the rest of 2011 and based on information available and our expectations as of today, we currently estimate the total cost of our food commodity basket to increase approximately 4% during the second half of 2011. As I mentioned earlier, we started seeing a more pronounced increase in our actual commodity costs towards the March period as compared to January and February. As such, I anticipate cost of sales for the remainder of 2011 to be around 25% or so.”
- “In regards to labor, we currently do not anticipate significant pressure for the remainder of 2011 for both wages and salaries. As such, the slight increase or decrease in labor as a percent of sales will be more based on the ability to gain leverage on our comparable restaurant sales.”
- “In general, I would expect to see some increase in operating and occupancy as a percent of sales for the remainder of 2011 due to some higher energy costs. We are still anticipating a 3% increase in these costs per operating week as compared to 2010. As such, much like labor, the change as a percent of sales in operating and occupancy will be more dependent on the leverage obtained from comparable restaurant sales.”
- “I would anticipate our G&A costs to be slightly less than Q1 costs as a result of some lower recruiting costs but in general I would anticipate G&A to be around the $9.7 million to $10 million per quarter including equity compensation. And as expected it would be slightly greater than that range in that quarter due to the extra week.”
Here is a comprehensive view of top line trends in the casual dining category heading into earnings season. Investors understand that commodity costs are elevated. The main battleground in the over-crowded casual dining category is growing same-restaurant sales. Most concepts in the category are still highly focused on attracting traffic through value-focused offerings with others focused on attracting traffic to quieter day parts while increasing turnover during busier times of the day.
Applebee’s has been an industry leader in the Bar & Grill category for some time and, along with Chili’s, is taking share from some of the weaker players. While I believe that Chili’s is momentum is improving at a faster rate than Applebee’s, I would be remiss to ignore the strong performance of the Applebee’s system over the past three quarters. With an easier compare, on a sequential basis, in 2Q than 1Q, I would expect Applebee’s system same-restaurant sales to accelerate on a one-year basis in 2Q. Furthermore, the trends in the Knapp Track casual dining same-restaurant sales index have been strengthening of late; given how important the Applebee’s system is for that index (its sheer number of units), I would expect the improving two-year average trends to continue. Indeed, any positive same-restaurant sales print for Applebee’s company sales would imply acceleration in two-year average sales.
IHOP is a disaster and, as the chart below illustrates, has been underperforming the broader casual dining space by a growing margin as time rolls on. Management is floundering in its attempts to provide promotions that will attract sufficient traffic and commentary highlighting the need to “better differentiate the customer experience to drive sales and regain momentum” does not inspire confidence. IHOP is a small part of DIN’s business but the lackluster performance is disappointing nonetheless.
BJ’s restaurant is currently being awarded a lofty multiple of 17.8x EV/EBITDA NTM. Considering that DIN is currently
trading at 9.3x, and is the second most highly-valued company in the casual dining space behind BJRI, investors are clearly willing to pay up for the unit growth potential that BJRI offers. In terms of top-line trends, the company bounced back strongly post-recession. Last quarter’s company same-restaurant sales growth of 7.8% growth was an acceleration from the comp printed in the fourth quarter of 2010 despite a far more difficult compare for the first quarter. Management struck a cautious tone regarding the second quarter, stating on March 20 that, excluding the shift in the Easter holiday and spring break vacations, same-restaurant sales were estimated to be trending at approximately +5.5%. This would imply a sequential slowdown in two-year average trends of 70 basis points.
Looking at California Sales Tax receipts for the second quarter, it seems that consumer spending in the Golden State was robust during April, May and June. The two-year average trend, however, in sales tax receipts was slightly down. Approximately half of BJRI’s restaurants are in California so the chart below suggests that strong 2Q trends could be in store for BJ’s California units.
Darden is a consensus long but unless you have a bearish outlook on the space, it would not be an ideal play on the short side either. DRI recently reported earnings for their fourth quarter and full fiscal year 2011 recently. As the charts below show, the three primary concepts all saw declines in two-year average trends from the third fiscal quarter. The Olive Garden same-restaurant sales disappointed; two new entrée dishes – soffatelli with braised beef and soffatelli with chicken – drove traffic in line with the industry benchmark but fell short on average check. Additionally, despite raising prices at OG in 4QFY10, management decided against it in 4QFY11. Rather, management will introduce a new core menu and related pricing during the present quarter, the first quarter of fiscal 2012.
Red Lobster’s top-line during the fourth fiscal quarter was strong but two-year average trends did decline 90 basis points sequentially to -0.4%. Management announced on the conference call that the Red Lobster value promotions, was having a big impact on same-store sales.
LongHorn printed a +6% same-store sales number for the fourth fiscal quarter, exceeding consensus expectations but implying a sequential slowdown in two-year average trends. LongHorn has been a consistent performer for Darden and has one last quarter of (relatively) easy comps before facing the +6.8% number of 2QFY11.
Morton’s is a company that has benefitted from the strong rebound in consumer confidence in higher income brackets. The rebound in equity markets (QE2) has corresponded with a steadying increase in the top-line performance of Morton’s on an absolute scale and, also, relative to the FSR Index. During the earnings call on May 4th, management stated that “The Morton's business continues to align perfectly with business travel and entertainment. Hotel RevPARs, as well as occupancy are on the rise, driven primarily from increased business travel Monday through Thursday.”
We would be of the opinion that, as much of a beneficiary as MRT has been of the rebound in capital markets, a slowdown from here could impact its business severely, as was the case in 2008. The company is guiding to margin expansion, driven by traffic and price (currently ~6% price on menu), in the second and fourth quarters of 2011 but expects 3Q to be “tough” due to lower traffic volumes over that period.
Ruby Tuesday’s CEO Sandy Beall’s statement that the Chili’s $6 lunch was having an impact on Ruby Tuesday’s lunch business was telling. Clearly the RT business is suffering but for the CEO to call out Chili’s specifically was significant. Given the size of the Chili’s system, the strong performance of the Knapp Track is also encouraging (as it is for Applebee’s). Another struggling casual dining competitor, CBRL, also highlighted “two very large chains” that are “on a big rebound” as being largely responsible for sending the Knapp-Track figures higher and the CBRL Gap-to-Knapp spread wider. The two chains CBRL management was referring to are obviously Chili’s and Applebee’s.
We believe that Chili’s will continue to execute from a top-line perspective in 2Q and, in the process, win over previously skeptical investors. Broad guidance for the year is for “flat-to-down 2%” but, given the strong trends in casual dining, per Malcolm Knapp’s data, it seems likely that two-year average trends will accelerate in 2Q. A print above -1.2% would imply a sequential acceleration in two-year average trends.
Ruth’s Chris is has seen solid improvement in its two-year average trends over the last three reported quarters. There are certainly many things to like about this name: a lower average check ($70) than many peers, positive traffic for five consecutive quarters, and the stock is trading at the lowest EV/EBITDA multiple of any restaurant company.
In order to imply two-year average trends in line with those from 1Q11, Ruth’s Chris comparable restaurant sales will need to come in at +1.8% or better. 1Q11 was a stern test for RUTH comps given the significant step up in the difficulty of the compare in 1Q10 and, given the strength of 1Q11 comps and overall industry trends, we would expect 2Q to produce strong top line trends. The company is benefitting from TV advertising which it rolled out in 1Q and, while “comping” the impact of this advertising may prove difficult, for this year it should provide a significant benefit.
Given the overall trend in casual dining, and the fact that confidence levels among higher income consumers, while declining of late, has not declined as sharply as confidence has among consumers in many other income brackets.
Ruby Tuesday’s sales trends were poor during the most recently reported quarter, the company’s third fiscal year of 2011, and management were quick to blame weather, high gas prices, and the economy for sluggish performance. Management also highlighted Chili’s $6 lunch and “two very large chains” (Applebee’s and Chili’s) taking share as thorns in RT’s side. It will be interesting to see if the fourth fiscal quarter, which reflects a period of relatively robust casual dining sales trends, also proves disappointing for RT.
4QFY11 comps for RT need to come in higher than -2.2% for a sequential improvement in two-year average trends. While it seems that this is likely, given the impact of weather on the first quarter, investors will look for strong improvement and convincing management commentary supportive of better trends. RT, at 6.6x EV/EBITDA, is currently one of the cheapest stocks in casual dining but I would look for more catalysts, and conviction on sales trends, before getting more constructive on this name.
Sales at both concepts have lagged the industry over the last couple of quarters and, taking the management team’s commentary around April into account, it seems quite possible that 2Q will disappoint also. Specifically, management stated that January and February results were in line, March surprised to the downside and, at both concepts, April trends deteriorated from there, down -3% excluding the -2% impact of the Easter calendar shift. In order for the Bistro to maintain two-year average trends in the second quarter, a same-restaurant sales number of -2.2% or better is required.
Pei Wei same-restaurant sales results were hampered in the first quarter by the fallout from an identity theft investigation focusing on Pei Wei employees in Arizona. According to management, the company will now be rolling out E-Verify for all new hires at Pei Wei. The Bistro already uses E-Verify.
Independent of the impact of the investigation on business in Arizona, there is concern about management’s ability to manage two concepts under one umbrella. The commentary around continuing soft trends (-3% excluding the -2% impact of the Easter calendar shift) in 2Q did little to raise investor optimism. In order for Pei Wei to sequentially improve two-year average trends, the concept needs to print same-restaurant sales better than -1%.
Texas Roadhouse is a company that we hold a negative fundamental view of. Traffic compares for TXRH get increasingly difficult over the next three quarters. Adding price to the menu may have a muted impact on the overall comp given the traffic-heavy nature of the same-restaurant sales number’s composition. The TXRH core customer is sensitive to gas prices and it is possible that high gas prices during the second quarter, while declining overall since early May, could have impaired the company’s top line. The stock is trading at a lofty multiple of 8.3x EV/EBITDA, the fourth highest of the casual dining space behind BJRI, DIN, and BWLD.
Buffalo Wild Wings is a company that has been performing well over the last twelve months, largely due to extremely favorable chicken wing prices, and same-restaurant sales improved significantly in the first quarter of this year. The second quarter faces an easy 2Q10 compare of -0.1%. In order to maintain sequential two-year average trends, BWLD will need to print company same-restaurant sales of at least 4.1%. Considering that April same-restaurant sales were up +5.3%, and Knapp Track trends in May were stronger than in April, it seems that an acceleration of two-year average trends in 2Q is probable, absent a slowdown in June.
Kona Grill has been a favorite idea of ours in 2011 and, as we wrote in June, the departure of former CEO Mark Buehler was not caused by business-specific factors. Furthermore, as we wrote at the time, business trends were in line with the company’s expectations and a remodel program coming through in 4Q11 will have a positive impact on comps. In order for Kona to maintain two-year average trends, same-restaurant sales of 5.4% or better will be required.
Conclusion: The Gang of Six proposal will likely pave the way to a debt ceiling extension, but a credible and detailed deficit reduction plan is still a mirage.
The stock market’s reaction to the Gang of Six deficit plan was without a doubt positive. The SP500 ended yesterday up 1.6% and the NASDAQ composite ended up 2.2%. This reaction was interesting given the credit markets have been signaling that any risk of a U.S. government debt default was minimal based on the fact that credit default swaps for U.S. government debt have not budged this year. The equity markets did, however, rightfully cheer on compromise in Washington, DC, even if default was never realistically on the table.
There is no doubt compromise in Washington, DC, especially in these partisan times, is indeed a good thing for America. While Republican leadership in the House continues to make noise about not being satisfied with the Gang of Six plan, the polls and American voters are shifting away from them. In the last few days two meaningful polls have been released that likely influenced some in the Republican leadership in the Senate to step away from stalemate on the debt ceiling debate. The key polls were as follows:
- CBS Poll on July 18th: This poll from CBS showed that 46% of those polled believed the debt ceiling should be increased and 49% were against it. Almost a month earlier, CBS ran the same poll and only 24% of those polled believed the debt ceiling should be raised and 69% were against it. Clearly, on some level, the dramatic shift amongst Americans as it relates to the debt ceiling is influencing a Republican willingness to compromise.
- Gallup Poll on July 18th: The key question asked in this poll was: “What would you like the people in government who represent your views on the debt and budget deficit to do in this situation?” Interestingly, in line with the shift noted in the CBS poll mentioned above, 66% of those polled indicated they would like their political representative to agree to a compromise plan, even if it is a plan they disagree with.
Given the shift in national sentiment it is likely not surprising that the Senate has come to a compromise and that is, as the equity market indicated, positive on the margin, at least in the intermediate term. Conversely, last night the more conservative House, influenced by the Tea Party, passed a $6 trillion deficit reduction bill with a constitutional balanced budget amendment. This piece of legislation has been dubbed “Cut, Cap and Balance”. In contrast to the Gang of Six plan, which has been lauded by President Obama, the House bill is very unlikely to find support in the White House.
In reality, passing “Cut, Cap and Balance” was likely more of a symbolic move. House Majority Leader Eric Cantor signaled as much when he stated the following about the Gang of Six proposal:
“This bipartisan plan does seem to include some constructive ideas to deal with our debt.”
This seems to imply that Cantor is ready to dance, which isn’t surprising given the polls are shifting away from him.
Our core issue with the Gang of Six proposal is its gross lack of detail, which potentially makes the ability to successfully implement the plan challenging. The key points in the five page memo are as follows:
- Cutting $500 billion in discretionary spending over 10 years, including defense;
- New discretionary spending caps through 2015;
- Requirement of congressional committees to produce legislation within six months that finds billions in savings in entitlement programs over 10 years;
- Creation of a 67-vote threshold to make it difficult for the Senate to exceed its spending caps;
- Overhaul of the tax code, eliminating many tax breaks and using the savings to reduce marginal income tax rates;
- Elimination of the $1.7 trillion Alternative Minimum Tax and the $298 billion Sustainable Growth Rate formula for Medicare (known as the “doc fix”); and
- An overhaul of Social Security.
Interestingly, this may be a way of kicking the can down the road on a grand scale as the Gang of Six plan will be utilized to extend the debt ceiling, but the real work on implementation and legalizing will come at the committee level and over a longer period of time, perhaps years.
In the Congressional Budget Office’s current baseline case from January 2011, the combined federal budget deficit from 2011 to 2021 is $6.9 trillion. Currently, Medicare, Medicaid and Social Security combine for 42.4% of annual federal budget outlays. By 2021, as outlined in the table below, these three programs will combine for more than half of federal budgetary outlays. In total, by shifting from 42% of federal spending in 2012 to 50%+ of federal spending by 2021, the combined programs of Medicare, Medicaid and Social Security are responsible for contributing an incremental $2.3 trillion to the deficit.
The math is pretty simple, if we want to solve the deficit problem, we need a credible plan to reduce future healthcare and social security spending. Without further detail on how this is going to be effected, it is difficult to get very excited about the Gang of Six proposal from a longer term prospective. In the shorter term, this plan will likely allow the debt ceiling to be extended. As far as being a credible deficit reduction plan though, the devil is in the as of yet unseen details.
Daryl G. Jones
Director of Research
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